Will New Mortgage Rules Benefit Big Banks?

The requirement that banks have some skin in the game was one of the few mortgage-related rules in last summer's financial regulation bill. It required banks to hold some portion of mortgages they originate, so they would be exposed to the loans' risk. That way, even if they securitize or otherwise sell the lion's share of their mortgages, they will have some incentive to care more about credit quality. There will be an exception to this rule for qualified mortgages that have certain characteristics, however. Some sources suggest that a 20% down payment will be required for banks to escape a 5% retention requirement. Will this benefit big banks?

Lorraine Woellert of Bloomberg reports that JP Mortgage CEO Jamie Dimon thinks that new rule is good news for mega-banks like his. Woellert writes:

It would help bigger lenders such as New York-based JPMorgan, the second-biggest U.S. bank by assets, because they "have the scale to hold the 5 percent of non-qualifying mortgages on their balance sheet," said Citigroup analysts Keith Horowitz, Craig Singer and Steve Foundos, citing Dimon.

Like in other ways, big banks certainly do have the scale to absorb this cost. But this isn't a new cost to some community banks. And do the giant banks have the patience and stomach for this risk retention?

You could argue that this new requirement would provide small banks an advantage. Community banks often hold some or all of their mortgages anyway, so they won't notice the 5% retention requirement. This new cost for the big banks might be absorbable, but for small banks it was already accounted for. As a result, the smaller banks don't face a new cost associated with writing mortgages with low down payments.

Community banks, then, could find a niche of providing lower down payment mortgages to borrowers in their respective communities who have non-prime credit or relatively short credit histories and little saving. They will have the patience to understand the risk that they're taking on, because they'll understand their regions and customers better than a global mega-bank. For the mega banks, they'll have to be more prudent when offering lower down payments, which might not provide enough return for the headache caused by holding the additional risk. After all, they can focus on the prime, large down payment business instead, where they can still enjoy a competitive advantage over smaller banks through their ability to distribute the loans through tools like securitization.

Moreover, the big banks took on huge losses due to soured mortgages during the bubble. Are they really going to be comfortable going back to holding a portion of the risk for loans with low down payments, which would provide little padding for future losses? While they might be able to endure the cost of holding capital, do they want that capital to be at risk? TheirĀ  loan origination techniques could be inferior to those of community banks that may better understand customers on the margins that don't have the cash for big down payments

Perhaps the mega-banks will develop stronger underwriting and shrug off the retention risk, as Dimon must assume. But if they don't, then community banks would benefit. That makes the big losers here the middle-market banks. They're the ones trying to compete with the big banks, often selling some mortgages and possibly participating in some securitization. Yet they might not be as close to their communities and customers as the smaller banks.

The new rule may create a barbell effect for a chart that shows mortgage market share versus bank size. The big banks would benefit from scale and sophistication, providing a strong grip on the prime, large down payment market. The small community banks would benefit from their solid relationships with their customers, which result in a clear understanding of the accurate credit risks. The mid-size banks, however, have nothing but relative disadvantages under the new rule.